MONETARY POLICY TRANSMISSION IN INDIA: EXPLANATIONS FROM THE MONETARISTS MODEL Prashobhan Palakkeel* Abstract Wealth adjustment process

has been considered as an analytical framework for explaining the black box dynamics of monetary policy transmission. specially monetarists models like !runner and "elt#er model $%&''( used the wealth adjustment process effecti)ely in order to explain the transmission mechanism of monetary policy. Although* most of these models are termed as monetarists models* +eynesian interest rate mechanism is well obser)ed in these models. While considering the large number of empirical studies on the monetary policy transmission* the number of studies* which used the wealth adjustment process as the analytical framework* is less. "oreo)er* most of the studies on sa)ings and in)estments in the economy failed go beyond their beha)ioral relations and in linking it with the transmission process. ,he present study is an attempt to fill these gaps in the context of -ndian economy. ,he study initially examines the sa)ing beha)iour of alternati)e institutions in the economy with special reference to the households sector. .ouseholds portfolio allocation process and interest rate reactions are examined through regression models. With the help of wealth adjustment process* it explains the monetary policy transmission in -ndian economy.

+ey Words/ "oney* "onetary Policy* ,ransmission "echanism* .ouseholds Wealth Portfolio

* 0octoral fellow in the -nstitute for 1ocial and conomic 2hange* !angalore 345 mail6 palakkeel7gmail.com* prashobh7isec.ac.in
*,he author is grateful to 0r. "eenakshi 8ajee) for her ad)ice and )aluable discussions.

Introduction xplanations to the dynamics of monetary policy transmission are generally concerned with 9uestions such as* how monetary policy actions work upon the economy or how the economic acti)ities are cataly#ed by the policy impulses etc. !asic macroeconomic frameworks hea)ily depend upon the dynamics of stocks and flows interactions in explaining the macroeconomic fluctuations. Accordingly* the impact of monetary policy upon stock and flow interactions is the basic en9uiry in most of the monetary policy transmission models. !ut the significance of specific relations is )aried in alterati)e frameworks used for the analysis. Wealth adjustment process is one of the established frameworks for analy#ing the transmission process of monetary policy % and in which initial impact of monetary policy is identified upon the financial asset portfolio. ,he restoration process of this stocks $assets( and interacti)e flows relations and consecuti)e changes explains how the policy impulses transferred into macroeconomic outcomes. 8ational economic agents maximi#e their utility function according to changes in their economic en)ironment. ,his basic economic rationality is 9uite )isible in the case of wealth accumulation process* where the agents are mainly concerned about the management of returns and risk in their possible wealth portfolio. Policy actions change economic en)ironment and related le)el of returns and risk associated with wealth portfolios. While considering sa)ing and in)estment decisions* households ha)e greater importance in most of the de)eloping countries. .ouseholds contribute the major share of total national sa)ings in se)eral countries like in -ndia. 1imilarly* households position in in)estment decisions in these countires is becoming more crucial in recent years in the light of new economic policy regimes 5. 0ue to these reasons* an analysis of monetary policy transmission in such countries like -ndia need special attention towards the households wealth adjustment process. Accordingly* this paper identifies the

!runner and "elt#er $%&''( produced the best monetarists model of transmission mechanism. ,his paper tries to incorporate the monetarists explanations to the transmission process. 5 :n an a)erage more than 4; percent of the total national sa)ings has been contributed by the households in -ndia. With the liberali#ation process the share has reached more than &< percent in some of the recent years.

households wealth adjustment process as the core of monetary transmission process in -ndia. "ore than beha)ioral relations behind assets and portfolio allocation* this paper concentrates upon the monetary policy transmission process. 1o major concern has gi)en to find out the suitability of existing theoretical frameworks in explaining the transmission process. Although* general trends in sa)ings and in)estment by )arious types of institution in the economy are presented in the next section elaborated discussion has made only about the households asset allocation process o)er the last three decades. ,he following section describes the transmission chain that explains how monetary impulses can influence the output changes through wealth adjustment process. 1.G n r!" Tr nd in S!#in$ !nd In# %t& nt in Indi!n Econo&'. 1a)ings and -n)estment beha)ior in -ndian economy has studied in detail by )arious authors=. ,hese studies showed significant changes in the sa)ing and in)estment patterns of )arious types of institutions o)er the past three decades in -ndian economy. ,hese changes are more or less continuous and systematic in nature and 9uite )isible in theyre respecti)e shares to the total national sa)ings and in)estments >. .ouseholds share in national sa)ings has been increased considerably o)er the period<. ,here is a similar change in the case of pri)ate corporates also $see table % and 5 in Appendix6-(. -n the regime of new economic policies* public sector sa)ings and in)estment shares deteriorated considerably and dissa)ings dominate in the later years. ,he a)erage growth rate of households sa)ings was around %4 percent during the period %&4;64% to 5;;56;= $see table.= in Appendix6-(. ,here was not much )ariation among the a)erage decadal growth rates. -f we see the a)erage growth rate of sa)ings by pri)ate corporate sector* there was not much difference from households a)erage growth rate. !ut the )ariation of decadal growth rate is comparati)ely high and for the period 5;;;6;% to 5;;56;=* pri)ate corporate sectors sa)ings a)erage growth rate was merely ;.%> percent. 2ompared to other two categories of institutions* growth rates of sa)ings by
= >

8aksit $%&'5(* ?irmani$%&&;(*8ay and !ose$%&&4(. 1ome of the studies specified the demand and supply constraints apart from structural breaks $see @oyal %&&%* 8ay and !ose%&&4( < ,he data used for the analysis are nominal in terms. )en in the case of growth rates also the argument for real )alues are not considered* as the objecti)e is to show the comparati)e positions of )arious types of institutions or assets. .andbook of 1tatistics on -ndian conomy 8!- 5;;>6;< is the data source.

public sector undertakings show significant )ariation during similar period. ,he decadal a)erage growth rate came down to six percent during %&';6'% to %&'&6&; from the earlier decadal a)erage of %4 percent. Although the a)erage growth rate was around nine percent* the )ariation in the yearly growth rate of sa)ings by public sector was the highest during the nineties. -nconsistency in the sa)ing beha)ior of public sector after %&&;s is mainly contributed by the liberali#ation process took place during the period. 1imilar to the case of sa)ings* a)erage growth rate of in)estment by pri)ate corporate is the highest during %&4;64% to 5;;56;= $see table.>.Appendix6-(. Pri)ate corporates in)estment also shows highest )ariation in the growth rates during period. ,he case is different from that of sa)ings* where public sector shows highest )ariation in the growth rates. ,here is a significant decline in the total in)estments after 5;;; and the a)erage growth rates were came down drastically in the cases of pri)ate corporates and public sector in)estment. ,he abo)e discussions show the dominant position* which households hold* in sa)ings and in)estment decision6making in -ndian economy. "oreo)er* changes in the sa)ing and in)estment pattern of )arious types of institutions o)er the period make the position of households more crucial. Pri)ati#ation of the economy* which associated with the liberali#ation process* handed o)er more responsibility in to the hands of households instead of transferring it in to pri)ate corporates. Although public sector and pri)ate corporates are maintaining their in)estment shares reasonably well* the households position is becoming more crucial especially in the recent years* as its share in total national sa)ings has increased considerably. ,he huge share* which households hold in the total national sa)ings* shows that any change in the households assets portfolio can exert considerable impact upon the sa)ing and in)estment patterns in the -ndian economy. 1.1. Hou% (o"d% S!#in$% in Fin!nci!" A%% t% ) G n r!" Tr nd -n a broad classification households sa)ings can be grouped in to two )i#.* financial and non6financial $physical( sa)ings. ,he residual between in)estment in financial assets and financial liabilities are e9ual to the financial sa)ings. ,he financial assets held by households comprise currency* bank deposits* non6banking deposits* shares and debentures* units of A,-* insurance fund* pension and pro)ident fund* claims

>

on go)ernment* and net trade debt. ,he financial liabilities comprise bank ad)ances* loans and ad)ances from co6operati)e non6credit societies* loans and ad)ances from go)ernment* loans and ad)ances from other financial institutions. ,he households total financial assets grew from 8s 5%%; crore in %&4;64% to 8s >%4B4< crore 5;;=6;>. ,he financial liabilities grew from 8s <&% crore to 8s '&'B< crore during the same period. "oreo)er the a)erage growth rate of financial liabilities $5;.'%( was little more than the growth rate of financial assets $%'.;(. ,here are some significant )ariations in the pattern of indi)idual assets accumulation o)er the period of %&4;64% to 5;;=6;>. With the financial liberali#ations especially after %&&;s* there ha)e been some abnormalities like bubbling growth in the accumulation of certain financial assets for some years. ,his phenomenon is especially )isible in the cases of units of A,- $%&&;6&%(* non6banking deposits $%&&=6&B( and shares and debentures $%&&%6&> and &&65;;;(. 1imilarly high negati)e growth can be noticed in the case of net trade debt during &'6&& and 5;;%6;5. ,hese reactions are )ery much consistent with the fluctuations that occurred in the financial market during similar years and reflect the higher le)els of risk associated with these markets. :n the other hand* the components of financial liabilities show a comparati)ely smoother growth path o)er the period. 1.1.1. Co&*o%ition!" +!ri!tion o, A%% t% !nd Li!-i"iti % in t( Hou% (o"d% Fin!nci!" A%% t Port,o"io. ,he compositional )ariation of financial assets and liabilities gi)es a better description of the allocation process in the households asset portfolio. ,he compositional )ariations of financial assets reflect the changes in households preference o)er alternati)e financial assets and in -ndian case it )aried significantly o)er the period %&4;6 4% to 5;;=6;>. "oreo)er these )ariations also reflect the associated risks in the financial markets. 2omposition of currency in households financial assets )aried from ;.<= percent to 5%.>& percent during %&4;64% to 5;;=6;> with an a)erage share of %%.B5 percent. !ank deposits ha)e the highest a)erage share $>;.%'( among all financial assets and it )aried between 5B.5= and <& percent during the period. ,he )ariation in the share of monetary assets was comparati)ely high and bank deposits showed the highest )ariation. 1imilarly*

<

)ariation in the share of households claims on the go)ernment was also 9uite high and it )aried from 3;.;& to %'.54 percent with an a)erage share of &.=Bpercent. Another major component in the financial asset portfolio is the pension and pro)ident fund and its share )aried from %5.&4 percent to 5>.%B percent with an a)erage of %'.54 percent. We can obser)e a continuous decline in the a)erage share of monetary assets o)er the last three decades but the trend was re)ersed in the recent years. ,he shares of currency* bank deposits* claims on go)ernment and insurance fund show positi)e growth in the new millennium $1ee table < and B in Appendix6-(. 0iffering from financial assets* the compositional )ariations in the households financial liabilities were minimal. !ank ad)ances comprises the major share of households financial liabilities and its a)erage share was around '; percent. While the a)erage shares of households loans from other institutions was around %% percent* the a)erages of households liabilities to the go)ernment and co6operati)e bodies were )ery minimal. 1... Hou% (o"d% Fin!nci!" A%% t% Accu&u"!tion ) / (!#ior!" R "!tion% .ouseholds demand for )arious financial assets in -ndia has been studied in detail by )arious authorsB. 1ome of the studies compared the demand for financial assets by alternati)e institutions like pri)ate corporates and public sector undertaking also. "oreo)er* some of the studies tried to link the sa)ings beha)ior with economic growth 4. 2ompared to other studies* the present study emphasis the influence of monetary policy )ariables upon the households sa)ings in financial assets. 1...1 Curr nc' 2urrency used to be an integral part of any households financial asset portfolio due to its distinguished characteristics like highest li9uidity' and le)el of acceptance. Although being a financial asset* currency has no direct return. !ut at some occasions* the property of highest li9uidity is an ad)antage o)er the opportunity cost* which the currency generally holds. ,he le)el of acceptance is greater for currency compared to any other forms of money and it is a necessity to hold money in the form of currency for smaller amounts of exchange. -ncreasing le)el of prices necessitates higher amounts of
B 4

1ee Pandit $%&&%(* 8ay and !ose $%&&4( 1hetty and "enon $%&';(* @oyal $%&&%( ' Ci9uidity of any asset should be assessed in terms of market )alue* capital certainty* marketability* reali#ability and re)ersibility.

money in the forms of currency in order to conduct the exchanges. !ut holding higher amount of currency leads to bear higher le)els of opportunity cost in the form of interest rates. ,he optimum 9uantity of any form of assets in the economy is determined by both supply and demand factors. -n -ndian case* the supply of currency is highly influenced by the financial position of the central go)ernment&. :n the other hand we ha)e se)eral demand factors like households income* expenditure etc. !ecause the demand for holding currency is primarily meant for exchanges* the major determining factor is the le)el of prices and expenditure. -f we consider the opportunity cost also* increase in the le)el of pries and interest rate are the major determining factors of demand for currency%;. 8egression results show that* the le)el of prices and interest rates are the major factors* which determines the amount of currency in the household assets portfolio. 8esults show that an increase in price le)el by one point $whole sale price index( will increase the demand for currency by %'& crores. 1imilarly an increase in interest rate $medium term bank deposits rate( will reduce the demand for currency by &%; crores.. 1ample period is %&4;64% t; %&&<6&B. ,here is a crucial break in the beha)ioral function after %&&B6&4. ,he break is due to se)eral reasons mainly associated with the financial sector reforms. 0ue to the complex mix of reasons the sample period is reduced to %&4;6 &B. Dor details see table.% in appendix 5. 1..... /!n0 D *o%it% !ank deposits can be considered as the dearest alternati)e to currency. -t has an added ad)antage of interest earning with a cost of less li9uidity compared to currency. -n the households total financial assets* bank deposits ha)e the major share. !ecause* bank deposits are generally considered as a major sa)ing instrument* the major demand factors for bank deposits can be the le)el of income* le)el of expenditure* interest earnings* yield from other sa)ing instruments etc. At present* )arious types of bank deposits are a)ailable for the households and the demand for each of them )aries according to their specific characteristics%%.
&

,he increase in currency in circulation is e9ual to the increase in rupee loans to the central go)ernment by 8!-. ,he issue of rupee loans is determined by go)ernments fiscal deficit. %; ,he impact of expenditure will be captured by prices %% Dor the analysis* only the aggregate deposits of households are considered.

,he regression results show that income le)el $proxied by gross domestic product( is the major factor determining the demand for bank deposits. -nterest rate differential $difference between medium term deposit rate and corresponding go)ernment security rate( also influences the households demand for bank deposits. !ut the coefficient is not much significant -ncome elasticity is greater than one for the demand for bank deposits. -t also shows that sa)ing rates increases with higher le)el of income. Dor details see table.5 in appendix5. 1...1 P n%ion !nd Pro#id nt Fund% Pension and pro)ident funds are other major ways of sa)ing by the households. ,he specific nature of these instruments shows that* it is more or less compulsory than discretionary to hold such a form of sa)ings in organi#ed sector. 1imilarly* employees from unorgani#ed sector are generally excluded from these kinds of sa)ing options. 0ue to these reasons* in aggregate form* the amount of household sa)ing in pension and pro)ident fund is mainly depend upon the le)el of employment in the organi#ed sectors* inflation rate $as a le)el of risk and determinant of current expenditure( and past le)el of sa)ings in the fund as it is a regular sa)ings etc. @o)ernments borrowing from these funds also influence the aggregate amount of households sa)ings in these funds as the earlier one critically determines the rate of return from these funds. 8egression results show that* all those factors described abo)e ha)e significant role in the determination of households sa)ings in pro)ident and pension fund. ,he income elasticity of demand is 9uite high and it shows that an increase in income $proxied by gross domestic product( will increase the demand for pension and pro)ident by <' percent. An increase in the le)el of employment in organi#ed sectors will increase the sa)ings in these funds by %B percent. @o)ernment borrowings from these funds also ha)e similar impact. Dor details see table.= in appendix 5. 1...2 In%ur!nc ,und 1a)ings in insurance fund is generally considered as a risk a)ersion mechanism. 8ecent years insurance options are a)ailable for a wide range of assets apart from life insurances. A)ailability of di)ersified options can change the nature demand for insurance options from mere risk a)erting instruments to major sa)ing instruments. -n aggregate form* the growth of households demand for insurance may not ha)e much

'

)ariation* due to long term commitments and recurring nature of payment. While considering the simple beha)ioral relations* regression result shows that inflation rate and pre)ious years sa)ings can explain the changes in households sa)ing in insurance fund significantly. Dor details see table.> in appendix 5. 1...3 C"!i&% on Go# rn& nt 1imilar to other market borrowers* go)ernments also issues )arious debt instruments in the market with )arying maturities and yield rates. .ouseholds demand for go)ernments debt instruments is generally depends upon the difference in the rate of return compared to other financial assets. :n the other hand the supply of go)ernment debt instruments is mainly depending upon the go)ernments financial positions.,he regression results show that* go)ernment market borrowings and yield differentials are the major factors determining the amount of households claim on go)ernment. Dor details see table.< in appendix 5. 1...4 S(!r % !nd D - ntur %. ,he households in -ndia ha)e not considered shares and debentures as major sa)ing instruments. Cess de)eloped financial markets and lower le)el of financial deepening may be the major reasons for this phenomenon. ,he major factors determining the households demand for shares and debentures are their le)el of income* price le)el* yield rates* risk and market conditions etc. 1upply of standard instruments in the markets also has greater importance in fulfilling households demand needs. @enerally* capital gains are the major moti)ation behind the households entry in to these markets than long term sa)ing plans. 0ue to this reason* price le)el of shares is a major factor* which determine the households sa)ings in shares. @enerally yield from other sa)ings instruments ha)e negati)e influence upon the in)estments in shares. 8egression results show that the expectations are )alid. A)erage le)el of prices in the markets and new capital offered for the publics are significant factors* which determines the households sa)ings in shares and debentures. Dor details see table.B in appendix 5. 1...5 S!#in$% in 6nit Tru%t o, Indi! S curiti % Anit ,rust of -ndia $A,-( is well6established financial intermediary in -ndia. -n)estment through A,- has considered as an alternati)e to self6in)estment in shares and

&

debentures or go)ernment securities. 8isk a)ersion is a major moti)ation behind the choice for in)estment through A,- apart from the yield rate. 1imilar to the expectations regression result shows that A,- di)idend rate and le)el of income $@0P( are significantly encourages the households sa)ings in A,-. !ut the increase in stock market prices has negati)e influence upon households sa)ings in A,-. Dor details see table.4 in appendix %. ,he abo)e discussions show that households sa)ings in certain financial assets are also influenced from supply factors. Apart from le)el of income* price )ariations and yield rates are the major factors determining the households sa)ings in most of the financial assets. Dinancial liberali#ation has significant influence upon households sa)ing in some of the assets. ,he analysis shows that monetary policy could exert significant influence upon the sa)ing beha)ior of the households as interest rates and price le)els are major factors determining the households demand for most of the financial assets. ..Mon t!r' Po"ic' Tr!n%&i%%ion !nd 7 !"t( A""oc!tion *roc %% "onetary authority manages the li9uidity in the system through controlling the )olume of money and credit. -n general monetary policy has two formsE i.e.* expansionary and contractionary. -n practice monetary authorities uses )arious policy frameworks according to their con)enience and policy actions )aries according to these frameworks. Ander money base control* expansionary monetary policy can be identified as an increase in base money or slash in reser)e ratios. :n the other hand under interest rate control* expansionary policy can be identified by a slash in official rate of interest. !ut sometime both controls are simultaneously used at )arious le)els with discretion. ,he simultaneity of frameworks makes it difficult to understand the exact policy moti)es by just obser)ing changes in policy )ariables. Dor example* for almost all6period* base money growth $nominal( has been positi)e in -ndian case. !ut the conse9uent changes in reser)e ratios and interest rates were contractionary in nature. -f we assess the nature of policy $as expansionary( based upon the increase in base money* the assessment will be contradictory with that one* which we makes based upon changes in reser)e ratios and interest rates. .ere we ha)e to identify the moti)ations behind each action in order to decide the real nature of the policy. -n -ndian case monetary authority was constrained to formulate contractionary monetary policy based upon monetary base due to fiscal

%;

pressures. 1o* most of the time* increase in base money just shows unintended actions rather than decisi)e policy actions. 1imilarly* hikes in the reser)e ratios and interest rates were the counter actions in order to nullify the impact of initial increase in the base money. !ut in these cases* the genuine policy actions can be recogni#ed as the changes in reser)e ratios and interest rates. "oreo)er expansionary or contractionary actions are totally depends upon the magnitude of these counter actions. ,he initiation of real action has crucial impact upon the transmission process as it directly modifies asset allocation process. 1imilarly* the direct impact of policy actions upon financial intermediaries and their acti)ities modify the acti)ities of households financial decision6makings. -f we start with increase in base money as the initial policy action* we can depict the transmission of monetary impulses as follows. -ncrease in the base money means increase in the currency $non interest bearing( component in the total money stock. Dinancial intermediaries will try to dispose the amount of increase through con)erting it into interest bearing financial assets or physical in)estments. 0emand for financial assets will reduce the interest rates in the financial markets. Alternati)ely intermediaries will be able to pro)ide increased amounts of loans and try to do that. -ncrease in supply of loans from intermediaries need a reduction in their interest rates. !ecause of cost adjustment* the reduction in interest rates will be extended in the case of their intakes from the public also $deposit rate(. ,he actions of financial intermediaries will lead to suitable counter actions from the public. Dirstly they will try for alternati)e financial assets or mo)e towards physical assets. We expect that both agents will react to the policy actions $an increase in base money( in such a way that their allocations will maximi#e their expected returns andFor minimi#e their associated risk. !ut the magnitude of these reactions will be related to their interest rate elasticities. ,he reactions of financial intermediaries are constrained by a larger extend. ,hey ha)e to follow center bank regulations related to reser)e ratios* interest rates and credit deployment etc. 1o the preliminary reactions may not take place freely. As mentioned earlier* monetary authority $especially 8eser)e !ank of -ndia for most of the time( target the second order reactions in order to nullify the effects of increase in base money* which used to be an unintended action but follows under fiscal pressure. Dor example* base money growth is necessarily generated from the fiscal imbalances in -ndian case. -n order

%%

to control the second order reactions which leads to price inflation* generally 8!increases the official interest rates and reser)e ratios following the increase in base money. 1o policy actions used to be the counteractions than the primary one. Drom the abo)e discussion we can frame the policy transmission through wealth adjustment process as follows. We can schemati#e the actions as follows %( 2hange in the official interest rates G 5( adjustment in the interest rate structure G =( financial asset allocation process $secondary adjustment in the interest rate structure and reallocation of assets( G >( changes in the proportion of financial and physical assets G <( changes output and employment. $Apart from these changes* changes in reser)e ratios constraints the resources a)ailable to distribute among all possible assets. Dor example cash reser)e ratio makes banks to assure capti)e currency holdings* statutory li9uidity ratio necessitates holdings of go)ernment securities.( While considering the financial intermediaries* sometimes there may not be needed much )ibrant secondary adjustment in asset allocation as in the case of public. .ere* the issue is the adjustment in interest rate structure and the control of financial intermediaries upon this adjustment. -f the intermediaries ha)e absolute control in the financial markets%5* they can control the structure of interest rate and which financial markets will follow. ,hen the secondary adjustment interest rate structure will be mostly related with financial markets and reallocation of financial resources will be much )ibrant in the case of public. ..1. T( Tr!n%&i%%ion Proc %%. We already discussed about the possible conse9uence of a contractionary monetary policy action on the interest rate structure. A hike in official interest rates generally leads to an increase in the a)erage interest rate and widening the range of interest rate spectrum $Digure %in Appendix6-(. 8iskier assets will be associated higher interest rate and it will attract some of the in)estors in these categories. ,he widened opportunity in financial assets will reduce the concentration of in)estment in few assets. -n other words* an increase in the spread of interest rate will reduce the compositional
%5

-n the cases of countries those ha)e less de)eloped financial markets* financial intermediaries like commercial banks dominates the financial decision6making related to credit deployment and financial in)estments in the economy

%5

)ariation of financial assets $figure.5 in Appendix6-(. ,he demand for )arious financial assets with the increase in opportunity will reduce physical in)estment. A reduction in the physical in)estment will leads to reduction in output and employment. :n the other hand* monetary expansion will ha)e a negati)e impact upon the interest rate spread $as the a)erage interest rate reduces( which will reduce the in)estment opportunity in financial assets and attract in)estors in physical assets. ,he impact can be a concentration of in)estment in few risk free financial assets $increase in compositional )ariance of financial assets( and increase in physical in)estment.%= ,he transmission process abo)e described can be schematically represented as -ncrease in official interest rate G -ncrease in interest rate spread G 0ecrease in compositional )ariation G 0ecrease in physical in)estment G0ecrease in output. -n the abo)e described transmission channel* the relationship between interest rate spread and compositional )ariation of financial assets is )ery important. As described pre)iously* secondary adjustments add simultaneity in their determination. ..1.1 E%ti&!tion R %u"t%. -n the abo)e described transmission channel* the determination of interest rate spread and compositional )ariation of financial assets are )ery important. ,he problem of simultaneity needs special attention in this case. Dirst we will find out the major factors determine the interest rate spread and compositional )ariation of financial assets and )erify the relationship between them. Drom the pre)ious discussion it is clear that major factors determine the interest rate spread are official interest rate* compositional )ariation of financial assets* monetary expansion and financial deregulation etc. :n the other hand* apart from interest rate spread and financial deregulation* income* pre)ious periods financial sa)ings and inflation rate etc can affect compositional )ariation of financial assets. ,he regression result shows that* interest rate changes and financial asset allocation has significant impact upon each other. !ut the estimated coefficients show that* the impact of financial assets allocation upon interest rate spread is considerably high compared to the re)erse case. -t suggests that* secondary adjustment in the interest
%=

1imilarly* financial deregulation process* which allows enough freedom to financial intermediaries in determining interest rates on their acti)ities* ha)e a positi)e impact upon the interest rate spread and it can contribute positi)ely to the output growth.

%=

rates as a result of the reallocation in financial assets will be 9uite high. 1imilar to the earlier discussion* increase in official interest rate widens the interest rate spread. :n the other hand* increase in li9uidity that can be measured through multiplier* significantly narrows the interest rate spread. ,he case was expected in the case of expansionary monetary policy. Appendix6--. 1imilar to interest rate spread* increase in income and inflation rate ha)e negati)e impact upon compositional )ariation of financial assets. -ncrease in interest rate spread gi)e a chance to spread the sa)ings in )arious financial assets. 1preading of financial assets among )arious categories reduces the risks and increases the a)erage return o)er the portfolio. ,he negati)e impact of inflation rate on the compositional )ariation is also shows similar risk pooling mechanism. 1imilarly* increase in the le)el of income* allow the households to select a broader array of assets and due to that reason* the coefficient of income shows a negati)e impact on the compositional )ariation of the financial assets. Pre)ious years financial sa)ing has a positi)e impact on the compositional )ariation of financial assets. !ut similar to that of inflation rate* coefficient is not much significant. Drom the results it is clear that the financial liberali#ation process has comparati)ely higher influence upon the composition of households financial assets than interest rate spread. "oreo)er* the regression results are 9uite similar to expectation made in the earlier discussions. ..1... Di%tri-ution o, S!#in$% / t8 n Fin!nci!" !nd P('%ic!" A%% t%. Another major issue related to the wealth allocation process is the distribution of sa)ings between financial and physical assets. ,he le)el of influence that monetary policy exerts upon this distribution is )ery crucial in determining the success or failure of any policy action. -f we consider the short6run dynamics* we can say that monetary policy works through demand management in the economy. "ore specifically* any expansionary policy action should be capable enough to raise the aggregate demand in the economy. -t necessitates more in)estment by the households $physical sa)ings( apart from consumption expenditure. :n the other hand* contractionary monetary policy will lead to lower physical sa)ings $in)estment( and a fall in output. 9uations are estimated in a simultaneous framework through Dull -nformation "aximum Cikelihood $D-"C( method and results are gi)en in table.&

%>

,he distribution total sa)ings into physical and financial in)estments can be influenced by se)eral factors like rate of interest* le)el of profits* le)el of income* le)el of prices* consumption pattern* expectations* business en)ironment etc %>. !ut the issue of major concern here is the influence of policy changes on this distribution. Dor simplicity* here we consider only two factors )i# the policy changes $through interest rate spread( and consumption expenditure as the major factors* which could ha)e considerable influence upon the distribution of households total sa)ings. Drom the earlier discussions* we expect that* increase in the interest rate spread $associated with the contractionary monetary policy( will exert a negati)e influence upon the share of physical assets. 1imilarly* we expect* consumption expenditure also exert a negati)e influence* because* along with the increase in consumption expenditure* people need li9uid assets in their in their hand. ,he regression results show that contractionary monetary policy reduces the share of households physical assets in their total assets. Dor detail see table.' in appendix --. -ncrease in the interest rate spread that is associated with an increase in official interest rate will reduce the composition of households in)estments significantly. As explained in the earlier section* increase in interest rate spread leads to di)ersification of financial assets and it will reduce the households preference for physical assets. An interesting result from the abo)e estimation is that* an increase in consumption expenditure reduces the composition of households physical assets more than to general reduction in their total sa)ings. -t shows that* along with the increase in consumption expenditure households prefer more financial sa)ings in order to facilitate easy exchanges. ,he empirical results show that wealth adjustment process can be effecti)ely used to describe the transmission process of monetary policy in -ndia. We can summari#e the discussion about monetary policy transmission process with the help of a schematic representation of de)elopments following an expansionary policy action. Cower official interest ratesG 2ontraction in the interest rate spread G xpansion in the compositional )ariation in financial sa)ingsG higher in)estment in physical assets G higher le)el of output
%>

!ut it is not able to assess the influence of all these factors separately due to different reasons $especially measurement problems and multicollinearity(.

%<

Su&&!r' ,he black box dynamics of monetary policy transmission is a conse9uence of complex beha)ioral relations of economic agents. Andermined or unidentified causal relations in the economy add enough complexities to this dynamic process. Any attempt to simplify the complexities needs well6established theoretical frameworks with enough flexibility. "ost of the studies related to sa)ings and in)estment in -ndian economy left out the policy influence upon the wealth adjustment process and corresponding linkages to output changes. 0ue to that reason* explanations to monetary policy transmission process in -ndian economy remained more or less with its black box dynamisms. -n this paper an attempt was made to explain the monetary policy transmission process under the broad framework of wealth adjustment process. 0ue to peculiar differences exists in the monetary regimesE distinctions are made for fruitful discussion. Although there are se)eral differences exists in -ndian case* the black box dynamics can be well explained under the broad framework of wealth adjustment process.

A** ndi9)I ,able .% 1hares of )arious institutions in national sa)ings Period A)erage sa)ings share by .ouseholds Pri)ate 2orporate Public 1ector 1ector 1ector %&4;64% to %&4&6'; 69.76 9.07 21.17 %&';6'% to %&'&6&; 75.03 9.06 15.91 %&&;6&% to &&65;;; 79.77 15.96 4.27 5;;;6;% to 5;;56;= 94.31 15.39 -9.71 %&4;64% to 5;;56;= 76.62 11.73 11.65
Digures are in percentages* 1ource/ .andbook of statistics on -ndian conomy 8!- 5;;=6;>

%B

,able .5 1hares of )arious institutions in national in)estment Period A)erage in)estment share by .ouseholds Pri)ate 2orporate Public 1ector 1ector 1ector %&4;64% to %&4&6'; 41.86 13.48 44.66 %&';6'% to %&'&6&; 35.49 19.08 45.42 %&&;6&% to &&65;;; 36.68 29.16 34.16 5;;;6;% to 5;;56;= 51.96 21.75 26.28 %&4;64% to 5;;56;= 39.28 20.68 40.04
Digures are in percentages* 1ource/ .andbook of statistics on -ndian conomy 8!- 5;;=6;>

,able .= A)erage growth rates of sa)ings by )arious types of institutions Period A)erage growth rate of sa)ings by A)erage .ouseholds Pri)ate 2orporate Public 1ector growth rate of total sa)ings 1ector 1ector %&4%645 to %&4&6'; 15.95 17.06 17.25 15.90 %&';6'% to %&'&6&; 18.16 18.32 6.17 16.08 %&&;6&% to &&65;;; 16.91 23.43 8.77 16.18 5;;;6;% to 5;;56;= 11.44 0.14 47.94 8.47 %&4;64% to 5;;56;= 16.52 17.86 14.01 15.35
Digures are in percentages* 1ource/ .andbook of statistics on -ndian conomy 8!- 5;;=6;>

,able .> A)erage growth rate of in)estment by )arious types of institutions Period A)erage growth rate of in)estment by .ouseholds Pri)ate 2orporate Public 1ector 1ector 1ector
14.58 17.88 17.16 15.37 16.49 18.42 28.28 22.62 -1.23 20.97 17.75 14.93 11.39 1.49 13.36

A)erage growth rate of total in)estment

15.45 16.63 15.46 7.20 15.05

%&4%645 to %&4&6'; %&';6'% to %&'&6&; %&&;6&% to &&65;;; 5;;;6;% to 5;;56;= %&4;64% to 5;;56;=

Digures are in percentages* 1ource/ .andbook of statistics on -ndian conomy 8!- 5;;=6;>

,able.< A)erage growth rates of financial assets of households during the period %&4;64% to 5;;=6;> % 5 = > < B Dinancial Assets !ank 0eposits 2urrency 2laims on @o)ernment -nsurance Dund Hon6!anking 0eposits Het ,rade 0ebt A)erage @rowth 8ate 5;.;< 4&.<< 655.=; %&.%% 5>.&% 6&5.%B %4

4 ' & %;

Pro)ident Dund 1hares and 0ebentures Anits of Anit ,rust of -ndia Dinancial Assets ,otal

%B.;' 6%5&.B' >&.>= %'.;;

Digures are in percentage* 1ource/ .andbook of 1tatistics on -ndian conomy 8!- 5;;=6;>

,able.B A)erage growth rates of financial liabilities of households during the period %&4;64% to 5;;=6;> Dinancial Ciabilities % 5 = > < !ank Ad)ances Coans and Ad)ances from 2o6operati)e Hon62redit 1ocieties Coans and Ad)ances from @o)ernment Coans and Ad)ances from :ther Dinancial -nstitutions Dinancial Ciabilities ,otal A)erage @rowth 8ate 55.'& ==.B' 5>.;& 5B.%% 5;.'%

Digures are in percentage* 1ource/ .andbook of 1tatistics on -ndian conomy 8!- 5;;=6;>

,able .4 A)erage 1hares of .ouseholds Dinancial Assets o)er the Period %&4;64% to 5;;;6;= % 5 = > < B 4 ' & Dinancial Assets 2urrency !ank 0eposits Hon6!ank 0eposits Cife -nsurance Dund Pro)ident Dund 2laims on @o)ernment 1hares I 0ebentures Anits of A,,rade 0ebt %&4;64& %=.&> ><.B% 5.&' &.;= %&.<B >.5= %.>< ;.>4 5.45 %&';6'& %%.'B >;.=5 >.B= 4.<> %4.>B %%.%> =.&; 5.5% ;.&> %&&;6&& %;.5B =>.4% B.4' %;.%= %'.'= &.>B 4.;> =.4' 6;.&' 5;;;6;= '.B> =&.&B %.'; %>.<< %<.B4 %4.>4 5.&= 6;.>& 6;.<> 4;6;= %%.B5 >;.%' >.>< &.<B %'.54 &.=B =.&& %.'> ;.45

Digures are in percentage* 1ource/ .andbook of 1tatistics on -ndian conomy 8!- 5;;=6;>

,able .' A)erage 1hares of .ouseholds Dinancial Ciabilities o)er the Period %&4;64% to 5;;;6;= % 5 = > Dinancial Ciabilities !ank Ad)ances Coans I Ad)ances from :ther -nstitutions Coans I Ad)ances from go)ernment Coans I Ad)ances %&4;64& '%.B5 '.%' '.>; %.'% %&';6'& 'B.5< 4.>< >.%& 5.%5 %&&;6&& 4&.;5 %<.<B =.<B %.'B 5;;;6;= '=.<= %5.'< 5.'= ;.4& %&4;6;= '5.>> %;.B& <.;' %.4& %'

from co6operati)es and non6credit societies

Digures are in percentage* 1ource/ .andbook of 1tatistics on -ndian conomy 8!- 5;;=6;>

Digure.% !ank 8ate and -nterest 8ate 1preadJ%

Digure.5. 2ompositional ?ariation of .ouseholds Dinancial Assets and -nterest 8ate 1preadJ5

12 10 8 6 4 2 0 78 80 82 84 86 88 90 92 94 96 Bank Rate 98 00 Interest Rate Spread

16 14 12 10 8 6 4 2 0 78 80 82 84 86 88 90 92 94 96 98 00 C VHFA Interest Rate Spread

Hote/ J%* -nterest rate spread is calculated by taking the standard de)iation of )arious interest rates. "ean interest rate of )arious categories of in)estment is used for the purpose. 1tandard de)iation of )arious a)erage interest rate $belongs to different categories of in)estment( is calculated for each year and plotted against the time. J5* 2ompositional )ariation is calculated by taking the standard de)iation of the proportion of )arious categories of financial assets in the total financial assets. ,he standard de)iation is calculated for each year and plotted against the time.

A** ndi9.II. R $r %%ion R %u"t% ,able%. 2urrency 2 K 54&<.'& L %'&.==*WP- 6 &;&.45*08 p6)alue $;.;=&5( $;.;;;;( $;.;;;;( Where 2 is the currency holdings by households* WP- is the wholesale price index* 08 is the medium term deposit rate. 86s9uared ;.&< Adjusted 86s9uared ;.&< 0urbin6Watson statistic %.&% Probability $D6statistic( ;.;;;; Mar9ue6!era Hormality ,est Mar9ue6!era %.%&%<B5 Probability ;.<<%%=5 %&

!reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.;;5;>< :bser)ed 86s9uared ;.&&4&<4 White .eteroskedasticity ,est D6statistic 5.;'<<B< :bser)ed 86s9uared '.&%;=';

Probability Probability Probability Probability

;.&&4&<4 ;.&&4>4% ;.%;&4>' ;.%%5B&=

,able.5. !ank 0eposits C!0 K 6<.B= L %.%B*C@0P L ;.;5*8 L NA8$%(K;.='O p6)alue $;.;;;;( $;.;;;;( $;.%;=4( $;.;5%=( Where C!0 is the households sa)ings in bank deposits* C@0P is the gross domestic product at market prices* 8 is the interest rate differential between medium term deposits and go)ernment securities. ,he prefix C stands for log6transformed series. 86s9uared ;.&& Adjusted 86s9uared ;.&& 0urbin6Watson statistic 5.%> Probability $D6statistic( ;.;;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era ;.%>==B% Probability ;.&=;'5' !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.=45==4 Probability ;.B&5B;B :bser)ed 86s9uared ;.''<454 Probability ;.B>5%&< White .eteroskedasticity ,est D6statistic ;.%5B>'; Probability ;.&'<%>; :bser)ed 86s9uared ;.4<<5>= Probability ;.&4&';;

,able.=. Pension and pro)ident fund CPD K 65.&; L ;.<44*C@0P L ;.%B*C "P 6 ;.;;>*-HDCL;.%<*C@PD L ;.=%*CPD$6%( p6)alue $;.;%=B( $ ;.;;>B( $ ;.;>%'( $ ;.%4=>( $ ;.;;B<( $ ;.;>4%( Where PD is the households sa)ings in pension and pro)ident fund* C@0P is the gross domestic productE -HDC is the inflation rate calculated from wholesale price index* C@PD is the go)ernment borrowing from pro)ident fund. ,he prefix C stands for log6 transformed series. 86s9uared ;.&& Adjusted 86s9uared ;.&& 0urbin6Watson statistic %.'% Probability $D6statistic( ;.;;;;;; Mar9ue6!era Hormality ,est

5;

Mar9ue6!era 5.B<&B>4 !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.;B'='% :bser)ed 86s9uared ;.%'%=%4 White .eteroskedasticity ,est D6statistic ;.''4;=4 :bser)ed 86s9uared &.<;54&=

Probability Probability Probability Probability Probability

;.5B><5> ;.&=>;'B ;.&%===; ;.<<&4'5 ;.>'<%>%

,able.>. -nsurance Dund C-D K ;.%< 6 ;.;;>*-HDC L %.;%*C-D$6%( p6)alue $;.;%>&( $;.;=';( $;.;;;;( Where C-D is the households sa)ings in insurance fund* -HDC is the inflation rate. ,he prefix C stands for log6transformed series. 86s9uared ;.&& Adjusted 86s9uared ;.&& 0urbin6Watson statistic 5.;4 Probability $D6statistic( ;.;;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era %.;;<<B= Probability ;.B;>'>B !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.;>5>%& Probability ;.&<'<=; :bser)ed 86s9uared ;.;&&B'< Probability ;.&<%=4& White .eteroskedasticity ,est D6statistic %.=&;'=' Probability ;.5<&;== :bser)ed 86s9uared B.4<'4B% Probability ;.5=&5;& ,able.<. 2laims on @o)ernment C2:@ K 6=.; L %.54*C@"! L ;.;B*P 6 ;.;;%*0 L NA8$%(K6;.>;O p6)alue $;.;<%%( $;.;;;;( $;.;;&<( $;.>;B'( $;.;=4;( Where C2:@ is the households claims on go)ernment* C@"! is the go)ernments net market borrowings* 0 is a dummy to reduce the heteroskedasticity problem and A8$%( for correcting the autocorrelation problem. 86s9uared ;.&; Adjusted 86s9uared ;.'' 0urbin6Watson statistic %.'' Probability $D6statistic( ;.;;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era =.B;&4&; Probability ;.%B>>&5 !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.%%5%=' Probability ;.'&>='4 :bser)ed 86s9uared ;.5'4;;4 Probability ;.'BB=%' White .eteroskedasticity ,est D6statistic %.B%%''' Probability ;.%4<44B :bser)ed 86s9uared %5.BB<<' Probability ;.%4'==% ,able.B. 1hares and 0ebentures C10 K %.%4L ;.&=*C!1 L ;.%'*CP 6 ;.=4*C8 p6)alue $;.;&&'( $;.;;;;( $;.;;;5 ( $;.=4<%( Where C10 is the households sa)ings in shares and debentures* C!1 is the annual

5%

a)erage of !ombay stock exchange index* CP is the new capital issued by companies offered to public and C8 is the maximum yield on long6term go)ernment securities. ,he prefix C stands for log6transformed series. 86s9uared ;.&4 Adjusted 86s9uared ;.&4 0urbin6Watson statistic %.<' Probability $D6statistic( ;.;;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era ;.5>%5B> Probability ;.''B=B; !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.''4%%% Probability ;.=<';'> :bser)ed 86s9uared %.;4;<4B Probability ;.=;;'%< White .eteroskedasticity ,est D6statistic ;.&%>5%< Probability ;.<=&&'< :bser)ed 86s9uared '.''=''> Probability ;.>>';B% ,able.4. Anits of unit trust of -ndia A,K 6&4B5.BB L &&;.>%*08 6 5.&*!1 L ;.;5*@0P 6 =B.B*0 p6)alue $;.;;%%( $;.;;5'( $;.;=B'( $;.;>B;( $;.;B45( Where A,- is the households in)estments in A,-* 08 is the A,- di)idend rate* !1 is the !ombay stock exchange index* @0P is the gross domestic product at market prices and 0 is a dummy to reduce heteroskedasticity problem. 86s9uared ;.4> Adjusted 86s9uared ;.B' 0urbin6Watson statistic %.45 Probability $D6statistic( ;.;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era 5.'&%;>B Probability ;.5=<B5= !reusch6@odfrey 1erial 2orrelation C" ,est D6statistic ;.%%=;&> Probability ;.'&='5% :bser)ed 86s9uared ;.=5B'%> Probability ;.'>&5>< White .eteroskedasticity ,est D6statistic 5.;;5=4' Probability ;.%54'<= :bser)ed 86s9uared %5.%>>>; Probability ;.%>>'44

,able.'. 0istribution of sa)ings between financial and physical assets. C.P1 K <.%= 6 ;.% *C-81 6 ;.;&*CPD2 p6)alue $;.;;;;( $;.;;=5( $;.;;;;( Where C.P1 is the share of households physical sa)ings out of total sa)ings* C-81 is the interest rate spread* C2 is the pri)ate final consumption expenditure and the prefix C6 denotes that* the series is log transformed. 0.67 86s9uared Adjusted 86s9uared ;.B> 0urbin6Watson statistic %.&4 Probability $D6statistic( ;.;;;;; Mar9ue6!era Hormality ,est Mar9ue6!era ;.>5=;>; Probability ;.';&=<= !reusch6@odfrey 1erial 2orrelation C" ,est

55

0.291113 D6statistic 0.675481 :bser)ed 86s9uared White .eteroskedasticity ,est 0.599693 D6statistic 3.308826 :bser)ed 86s9uared

Probability Probability Probability Probability

0.749747 0.713381 0.700516 0.652491

,able.&. Dull -nformation "aximum Cikelihood $D-"C( stimates C-81 K 3.476 %.<'C2?DA L%.B;C!8 6 %.&4C" L ;.=%0 p6)alue $0.3406( $0.0513( $0.0114( $0.0437( $0.0032( $0.1112( $0.1460( $0.1347(

$%(

C2?DA K 4.; 6 ;.%4C-81 6 ;.B>C@0P L;.=&C.D1$6%( 6;.;BC-HDC L ;.%'0 $5( p6)alue $;.;;;;( $0.0510( $0.0703( Where C-81 is the interest rate spread* C2?DA is the compositional )ariation of households financial assets* C!8 is the bank rate* C" is the money multiplier* 0 is the dummy )ariable characteri#es the financial deregulation process with the break point at %&&5* C@0P is the gross domestic product* C.D1 $6%( is the pre)ious periods households financial sa)ings* C-HDC is the inflation rate and the prefix C6 denotes that* the series is log transformed. ,he assigned instrumental )ariables are C!8* C@0P* C.D1 $6%(* C"* C-HDC and dummy. Cog Cikelihood K 5<.=4 0eterminant residual co)ariance K ;.;;;= 9uation $%( 86s9uared K ;.4& Adjusted 86s9uared K ;.4B 0.W. K 5.;4 9uation $5( 86s9uared K ;.4> Adjusted 86s9uared K ;.B' 0.W. K 5.%<

R , r nc !runner*+. and "elt#er*A. $%&''( Q,he Place of Dinancial -ntermediaries in the ,ransmission of "onetary PolicyR* American economic Review* =4=6='% 8aksit " $%&'5(Q-ncome* 1a)ings and 2apital Dormation in -ndiaR. Economic and Political Weekly* )ol %4* <B%6<45. ?irmani*A.$%&&;( Q1a)ing Performance and Prospects/A .istorical Perspecti)eR* in 0atta 8oy 2houdhury and !agchi $ed.s( -ssues*Hew 0elhi* ?ikas* %B=6%&5 0omestic 1a)ings in -ndia ,rends and

5=

8ay P and 0 !ose $%&&4(* Q@rowth* 1a)ing and -n)estment in the -ndian &&6%>>

conomy/

,rend* 2omposition and 8elationshipR* Reserve Bank of India Occasional Papers ?ol %'* @oyal A*$%&&%( Q0emand and 1a)ing 2onstraints in the -ndian conomyR. IGIDR Working Paper !.C.Pandit $%&&%( Q,he @rowth and 1tructure of 1a)ings in -ndiaR* :xford Ani)ersity Press* !ombay. ,he .andbook of 1tatistics on ,he -ndian conomy $5;;=6;>(* 8eser)e !ank :f -ndia.

5>